Opportunity Cost

What is opportunity cost? Opportunity cost refers to the value a person could have received but passed up in pursuit of another option.

So if you were to wait in line for free ice cream, you actually give up the opportunity to do something else with your time, like working at a job or reading a book. So that ice cream really isn't free. Economists even use the concept of opportunity cost to determine if people can benefit from trading with one another.

Let's look at a simple example -- just two people, Bob and Ann, who produce just two goods, bananas and fish. Because of the concept of opportunity costs, Ann and Bob are worse off when they try to do everything themselves. Here's what Bob can do if he spends all of his time producing only one good. Bob can either gather 10 bananas, or he can catch 10 fish. And Ann can either gather 10 bananas or catch 30 fish. Bob has to choose to gather bananas or catch fish. When he chooses to gather 1 banana, he gives up 1 fish. In essence, Bob trades with himself. He can use that time to gather bananas or trade that time to catch fish, and the cost of that trade is 1 fish per banana. That's Bob's opportunity cost.

The same holds true for Ann, but her cost of producing 1 banana is 3 fish. In the amount of time that it takes Ann to gather 1 banana, she could have caught 3 fish. She trades with herself 1 banana for 3 fish. So Bob only has to give up 1 fish to produce 1 banana, but Ann must give up 3 fish to produce 1 banana. Ann's opportunity cost of gathering a banana is higher than Bob's.

If Ann and Bob are allowed to trade with one another, they may be able to gain from specialization if Ann focuses on catching fish, and Bob focuses on gathering bananas. Because our time is valuable, any decision we make has a cost. If we focus our time on tasks we're good at, like Ann and Bob, then we end up in a better position than if we try to do everything ourselves.